Reply #21: Another Snippit from DailyReckoning [View All]

[Demeter]

As we pointed out at the end of last week, all the latest products of Wall Street had a bit of Ponzi in them. Ponzi was a schemer from the early 20th century who figured out that he could pay people a high rate of return...entice more money into his hands...and pay the first investors’ yields with the capital investments from the last. It worked beautifully for people who got in early. But Ponzi schemes always blow up. The problem is essentially the same in all extraordinary financial episodes – from the South Sea Bubble to the Dotcom Bubble...to the Housing Bubble.

“Finance” itself adds very little to the world’s wealth. And the returns from “finance”...or, broadly speaking, from investing...can never actually exceed the real rate of wealth creation in the economy – at least, not for very long. Most financial activity is merely shuffling money from one person to another...giving the financial industry an opportunity to collect a toll along the way. But when a Bubble gets going, it begins to look as though there is a lot more wealth available to shuffle. The act of financing, itself, causes the value of the thing financed to rise. The first people in – who bought at low prices – make money. People coming in after them think they are buying into a booming market and bid up prices. What they are really doing is transferring money to the early investors – just like the late arrivals to a Ponzi scheme.

George Soros described the process as follows:

“Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available